New college graduates may find themselves in a bind. They have significant student loans to pay off, but they also have a 401(k) to fund. So what should they do?
The best way to approach this question is to simplify it. For starters, funding a 401(k) is saving money. Paying off student loans is paying off debt. Reframing the question like this makes it easier to answer. Fundamentally, we are asking whether it is better for recent grads to save money or to pay off debt.
Even the simplified version of this question can seem daunting at first, as there is a lot to consider. Thinking about your current budget, your future income, tax consequences, the power of compound interest and the amortization of your student loans is enough to make anyone's head spin.
The Short Answer
Fortunately, there is another way to think about the problem. Instead of having to do the math dollar for dollar to figure out what you should do, consider this: 401(k)s -- assuming you choose to invest in stocks and bonds within them -- usually earn a higher rate of return than the interest rate payable on student loans. Stocks typically grow at a rate of 6-8% per year while student loans carry an average interest rate of 4-5%.
The difference in those interest rates answers the question. If the money you save in a 401(k) will grow faster than the debt of your student loans, it is better to put money into your 401(k) than to pay down your student loans.
Situations Where Paying Down Student Loans is Best
Of course, the devil is in the details. If the stock market were to crash and didn't fully recover for 10 years, it would mean your 401(k) would not grow faster than the debt on your student loans. While a stock market crash is possible, most people trust the market to deliver at least modest returns over time. This is especially true for long-term investors, like 401(k) holders, who put their money in the market and keep it there for a decade or longer.
Another problem may arise if you have especially expensive student loans. If your student loan interest rate is very high, at say, 6 or 8%, then you have a problem. When your student loan interest is high, it has the potential to outpace your 401(k) earnings if the account doesn't grow at that rate or faster. In this case, you do want to pay off your student loans first.
While a strong stock market return could grow your 401(k) at 10% or more a year, there is no way for you to guarantee that will happen. Smart investors do not hope for miracles. If your student loan interest rate is above the average growth of the market -- in other words, higher than 6 to 8% -- then do the safe thing and pay off your student loans. No one can predict what the market will do.
It's Not All or Nothing
Up until now we have looked at this as an all-or-nothing prospect: Either you throw all your extra money at your 401(k), or you give all your extra money to your student loans. But it does not have to be that way. In some cases, it shouldn't be that way.
Check if your company matches contributions to 401(k)s. Not every employer does this, but about half of them do (fewer companies match in times of recession).
When your company matches 401(k) contributions, it adds a dollar to your 401(k) for every dollar you put in, up to a set percent of your salary. For example, if your employer matches up to 3%, it will match your 401(k) contributions, dollar for dollar, up to 3% of your salary.
This is essentially a 3% bonus added onto your salary. Some financial experts refer to it as 'free money,' or like doubling your contribution amount. Whatever you want to call it, it's significant to your bottom line.
In fact, 401(k) matching is so good that even if you have expensive student loans, it may be a good idea to still invest enough money into your 401(k) to earn the employer matching. Just don't go overboard. Put just enough money into your 401(k) to max out your employer's match, then stop there. Save the rest of your money to pay off those pricey loans.
A Word About Taxes
There are tax consequences to saving into a 401(k) and to paying off student loans. 401(k) contributions come out of pre-tax dollars, so maxing out your 401(k) will reduce your tax bill slightly. Your student loan interest is tax-deductible, so that also helps reduce your tax bill but not by much. Ultimately, there are no strong benefits to either option when your income is low. When you make more than $70,000 a year, then the calculations will generally favor investing in your 401(k) over paying off student loans.
If your employer offers to match your 401(k) contributions, it may be wise to take advantage of the free money by contributing enough to get the maximum match and then use any extra money you make to pay down your student loans. Before either of these things, be sure to save and build up an emergency fund for unexpected car repairs or medical bills. After all, you can't pay down debt and save for the future if you can't take care of yourself in the present.
